The following is an edited excerpt from my book WEALTH: Simple Tips for Young Professionals.
Focus on your net worth
If there’s only one figure that you should focus on when it comes to your finances, it should be your net worth. In simple terms, your “net worth” is your assets minus your liabilities*.
If you increase your assets, your net worth increases.
If you decrease your liabilities, your net worth increases too.
From a net worth perspective, putting a dollar towards paying off debt is the same as putting a dollar into a savings account.
Repaying debt is often a great investment
Many times, paying off debt can be the best investment you can make.
If you earn interest or dividends, you are taxed on that income. So a 6% return will look more like 4% after factoring in tax. If you have a loan where you’re paying an interest rate of 5%, you aren’t paying tax on that “return”, so the net return is actually better for you.
Usually, investments involve a degree of risk. The higher your potential return, the more likely you’ll lose money at some point. When you repay debt, there’s basically no risk. You’re essentially getting a risk-free return.
In most cases, you can think of repaying debt as making a risk-free, untaxed return on your investment.
I’d qualify this in a few ways.
- If you pay some loans off, you may incur break costs, and these should be factored into any decision to repay debt.
- Some debts also aren’t worth paying off quickly. If you’re living in New Zealand, your student loan is interest-free, and is also extinguished if you die. If anything, you’re incentivised not to pay it off early.
- Some debt can be “good debt”, particularly where it is tax deductible and/or used to buy an asset that will generate a positive return over time (for example, buying the right property, or paying money to buy into a profitable business).
- Despite the above, do not use this as permission to borrow money to buy things you can’t afford! For example, don’t use this as a way to rationalise borrowing money to buy a car. The net result of this decision is to put you in worse financial shape.
* Although you can include the stuff in your house (your contents) and your car(s) as assets, when I think about my asset and net worth position, I tend to write them of as being worth nothing. So technically, I look at an adjusted net worth figure that doesn’t include lifestyle assets.